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STABLE-VALUE FUNDS OFTEN ARE THE MOST conservative investment option offered in retirement plans, and holders tend to view them as high-yielding cash substitutes. The funds typically carry insurance guarantees that enable investors who withdraw or transfer their money to do so at the assets' book value, or the value of the investments at the time they were purchased by the fund, plus credited interest.

Tom Bloom for Barron's

In recent years, however, some of these supposedly conservative funds reached for higher yields, despite the higher risk -- and now are sitting on market losses amid credit-market turmoil. That may force them to lower the interest rates they offer investors, and limit the ability of retirement-plan sponsors to transfer the plans to other stable-value providers.

In rare cases where plan contracts are prematurely terminated and insurance is discontinued, investors could receive the current market value of the assets, instead of book value, which is higher. A Chrysler fund that liquidated earlier this year paid employees and retirees only 89 cents on the dollar.

The Barclays index reflects a 40% investment in mortgage-backed securities, 25% in Treasuries, 18% in corporate bonds, and 4% in commercial mortgage-backed securities. That allocation might seem too aggressive for a product that some stable-value-plan sponsors restrict to government and agency-backed debt, but ING's strategy went even further. Each account has its own asset weighting, and is uniquely managed. At least some core-plus accounts, however, invested roughly 56% in mortgage-backed securities, almost 7% in commercial-mortgage-backed securities, about 30% in corporates and only 14% in Treasuries at year end. They could also invest up to 20% of funds in high-yield or emerging-market debt.

The deferred-compensation plan of the City of San Jose, Calif., invested in the ING Stable Value core-plus option and had a market value of $194.2 million at the end of the first quarter -- 17% below the $232.6 million book value of the plan's holdings. San Francisco's Employees' Retirement System had a similar experience with an ING product; at year end, the market value of this retirement-plan option was 15% below book value. The fund no longer is managed by ING.

The San Jose account had about 20% invested in collateralized mortgage obligations as part of its allocation to mortgage-backed securities, and about 9% invested in financial companies' debt as part of its corporate-bond allocation, plan documents indicate. The same was true of San Francisco, according to market sources. Both investments suffered losses.

It is unclear how many other stable-value funds have suffered market losses, as there is no public listing of the funds' market value. Stable-value funds are considered insurance products, not investment securities, and thus aren't required to disclose market value nightly, unlike money-market funds. Nor are stable-value funds registered with the Securities and Exchange Commission.

Chris Tobe, a senior consultant with Breidenbach Capital Consulting, estimates that up to a quarter of the industry's funds have a market value below 90% of book value. The losses resulted from the funds' investing in residential and commercial mortgage-backed securities, he says.

ING SAYS INVESTORS WHO WITHDREW or transferred money from these accounts didn't experience losses, because the insurance that ING provides while managing the accounts helps cover any shortfall between book and market value. In an e-mail response to Barron's queries, an ING representative wrote: "Even for plans that experienced a high degree of portfolio-level volatility, the insurance protections available through our product preserve participant-account principal and credited interest. Further, our guarantees of principal and accumulated interest in participants' accounts remain in place, and we stand by those guarantees to all of our stable-value clients. As markets recover, we are confident that any plan sponsors whose plans may have experienced market-to-book-value deficits will see improvements in the long-term in the valuation of their stable-value investment portfolios."

ING also notes that plan sponsors decide how their stable-value plans are invested. It says it offers the sponsors up to six investment options, ranging from conservative Treasury portfolios to the most aggressive option, the core-plus fixed-income portfolio.

City of San Jose risk manager John Dam confirmed that ING's pitch in 2006 offered many different strategies. The city opted for the core-plus offering because in 2006 it had the best 10-year return on investment. But Carol Cypert, the deferred-compensation manager for the San Francisco Employees' Retirement System, says that the core-plus strategy was the only separate-account structure offered in ING's proposal to San Francisco.

While investors who cashed out of either fund got their money at book value, those still invested may earn less interest. That is because a drop in market value can prompt the fund's manager to lower the crediting rate, or interest rate applied to accounts. If the manager offers a crediting rate below the cash return on the fund's investments, the excess cash can be applied to the fund's market value.

In the case of the San Francisco fund, ING offered to lower the fund's future crediting rate to 1.74%, from last year's 5.15%. In San Jose, it lowered the crediting rate to 3% from the 5% it previously had paid. By mandate, some funds have a minimal crediting rate, but the San Francisco plan didn't. The same holds for Morgan Stanley (MS), which offers a stable-value plan among its 401(k) options that was yielding nothing as the end of last year.

MOST PLAN SPONSORS DON'T PUBLICIZE the market values of their stable-value funds, but investors can obtain the information by inquiring. If the market value is below stated book, chances are the fund will be under pressure to reduce the crediting rate. Likewise, if the plan sponsor opts to terminate the contract and change stable-value providers, it may be difficult to find a new insurance guarantee.

The Bottom Line

Investment plans run by San Francisco and San Jose suffered losses on an ING strategy involving stable-value funds. At issue: widening discounts between market and book values.

As its stable-value fund deteriorated in value, San Francisco had several choices. It could stay with ING, which was offering a reduced 1.74% crediting rate. It could hire a new manager for incoming money, and enter into a "book-value settlement" with ING for existing funds, under which ING would continue to manage the assets for up to 10 years, giving most of the bonds in the portfolio a chance to mature instead of selling them in the current market at a loss. In those 10 years, ING would continue to guarantee that investors receive book value on withdrawals or transfers, but the crediting rate could fall to zero.

Lastly, the city could opt to move its investments, at market value, to another manager, which it did after determining that Great-West Life and Annuity Insurance offered lower fees, enhanced education tools and a more conservative approach, says San Francisco's Cypert. It also separated the triple-A-rated, government-backed securities from the troubled ING assets, investing new money in the former. The troubled assets are being "repositioned" as the market permits, but the city was unable to find a new insurer to guarantee the distressed assets.

Stable-value funds have mushroomed into a $520 billion business, according to the Stable Value Investment Association. They are likely to remain an important component of 401(k) and other retirement plans. Given the credit markets' troubles, investors should understand the risks inherent in such vehicles. Above all, they should recognize that these funds only look like cash.